REITs or Real Estate Investment Trusts are companies that focus their operations in real estate ownership and management. These companies are usually in the business of owning and acquiring properties or acting as landlords. REITs are pass through equities in which the company pays no federal income tax. It is beneficial for a company to be REIT as it does not have income tax obligations on the corporate level. These savings on taxes are passed on to the individual investors. In return, these companies distribute at least 90% of earnings to shareholders in the form of dividends, resulting a very high yield. The same can be seen in the following table.
REIT industry has been growing over the decades to over $1 trillion in market capitalization and has over $2 trillion in total assets. Given such a huge industry, S&P changed its Global Industry Classification Standard or CIGs system to make REITs its own sector, instead of grouping REITs into finance. This indicates the rising significance of REITs in the overall stock market.
Moreover, because REITs are high yielding dividend income source, they are a good source of secured income for many investors. Many dividend investors are conservative by nature and focused on generating safe, growing income while preserving their capital. Investment in REITs provides you the best option, compared to owning and managing your own rental properties.
REITs are however sensitive to interest rates. This is because of the business model is such that its growth capital comes from debt or equity. The higher interest rate means higher borrowing costs.
Despite their unqualified dividend status and interest rate sensitivity, REITs have proven to be an amazing long-term wealth-building tool over long periods of time especially for high yield investors. They also serve the income investment purpose for retirement savings. Strong dividend income and capital appreciation opportunity are two attractive features of investment in REITs. Now the question is how should you invest in REITs?
Types of REIT
You could invest in a stock exchange listed REIT or purchase shares in a REIT mutual fund or exchange traded fund (ETF). Investors also can invest in public non-listed REITs and private REITs. There are two types of REITs: Equity REITs and Mortgage REITs. The two types give investors the opportunity to invest in either equity financing or the debt financing of real estate.
Equity REITs are those real estate companies who buy commercial properties and lease the space in the structure to tenant who pay rent. After paying the expenses related to the operating of their properties, Equity REITs pay out most of the income annually to their shareholders as dividends. Equity REITs also include capital appreciation from the sale of properties in the dividends they pay.
Better REIT total returns against the broad stock market (Source: reit.com)
On the other side, Mortgage REITs invest in real estate mortgages or mortgage backed securities, and generates income from the interest on these investments as well as from the sales of mortgages. Mortgage REITs earn their profit from the difference between the income they receive and their costs, including their funding costs to buy mortgage investments.
Things to look for while investing in REIT
Like all companies, which are publicly traded, stock exchange listed REIT shares are priced by the market throughout the trading day. To assess the investment value of REIT shares, you need to see the potential growth in earning per share, overall return from the stock, and the prevailing dividend yield.
You should also analyze the present dividend yield against yield-oriented investments like bonds, utility stocks and other high-income investments. Other factors like dividend payout ratios as a percentage of REIT FFO, management quality and corporate structure as well as underlying asset values of the real estate or mortgages and other assets needs to be analyzed.
Furthermore, you need to look at 2 additional things while investing in REITs.
- REIT should able to increase earning reliably. You should look for companies with properties in which rents are below current market levels as these properties provides upside potentials in table market and downside protection when economic growth slows.
- REIT management is efficient to make a decision to quickly and effectively reinvest available cash flow while creating new strategies for revenue opportunities.
After investing into REITs, you also need to measure its performance by analyzing growth in net income or trend in fund flow from operations, occupancy rate as well as growth in property portfolio.
REITs are good investment options for those who secure consistent and assured income. Additionally REITs allow anyone to invest in portfolio of large-scale properties the same way they invest in other industries through purchase of stock. I think that owning REITs is the most efficient way to benefit from the real estate sector of our economy.